Capital gain exclusion change could present back tax refunds

The Colorado Department of Revenue recently reviewed its guidance for application of the state’s Capital Gain Exclusion and corrected its position of how it should be applied to pass-through entities. With this change comes potential opportunities for partners of partnerships and shareholders of S corporations that have recognized capital gains in the past four years to amend their returns and claim refunds of back taxes paid.

For the past 23 years, a law has been on the state’s books allowing for some capital gains to be excluded from Colorado taxable income in certain instances. The amount of the exclusion and the circumstances in which it applies have changed many times since the law’s original passage. Since June 4, 2009, the exclusion has been capped at $100,000 per qualified taxpayer per year, and is applicable to capital gains recognized on the sales of: tangible personal property acquired on or after May 9, 1994, and held for five uninterrupted years, or Colorado-located real property acquired on or after May 9, 1994, and on or before June 4, 2009, and held for five uninterrupted years. At the full $100,000 exclusion, the taxpayer would save upward of $4,630 of state taxes.

It is common for real estate to be held within an entity, such as an limited liability company. This strategy allows multiple investors to pool their funds to purchase the property, or can allow for estate planning by spreading interests among family members.

Until recently the Department of Revenue’s guidance on applying the exclusion to gains recognized by these pass-through entities was to consider the entity itself a “qualified taxpayer” and, as such, requires the $100,000 limit to be applied at the entity level. Therefore, the entity’s owners would split their share of this $100,000 limit. The limit would be further split in instances of tiered ownership, such as one LLC owning an interest in another. In that case, the individual members of the upper-tier LLC would be allocated only their portion of what was allocated from the lower-tier LLC.

In a recent review of their guidance, the department surprised many tax professionals and taxpayers by changing this stance. Instead, the limit should be applied at the partner and shareholder level. The entity should provide information about the sale to each owner, allowing them to calculate their exclusion as if they sold their prospective share of the property. Therefore, each owner could potentially claim a separate $100,000 exclusion on a single sale. In fact, depending on the ownership structure of the entity, a large gain could be completely exempt from Colorado tax.

This change in position is available for any returns currently in statute. This means that, of course, it should be used for returns still to be filed, but also it can be applied retroactively. Colorado’s statute of limitations for tax filings is four years from the date the return is filed, but no earlier than the original due date and no later than the final due date (including extensions, if applicable) of the returns. Therefore, for most calendar-year filers, the 2014, 2015, 2016 and 2017 tax years are currently open. Taxpayers should take a second look at their returns for these years, and if they have any capital gains flowing through a partnership or S corporation, potentially amend to claim these refunds.